Can State Win Its Pension Gamble?

Los Angeles Times, 8/14/06.

By Evan Halper

David Crane is a gifted investment banker who shared his expertise with government until he was dumped from a state board that invests teacher retirement funds.

Lawmakers bounced him from the board, one of the biggest players on Wall Street, after he repeatedly questioned whether state pension funds could earn enough to keep paying retirement benefits to teachers and other politically powerful employees.

Democratic legislators, who receive millions in campaign donations from teachers unions and other government labor groups, said it wasn’t Crane’s job to meddle in investment forecasts. California’s numbers are in line with those of other states, they note, and its pension investments have beat projections over the last 20 years.

But Crane, a close friend of Gov. Arnold Schwarzenegger, represents a cadre of market gurus who see investment profits flattening. They worry that state pension systems are heading down the same path as corporate retirement plans that hit trouble after failing to meet rosy earnings projections.

Several government pension plans are already deep in the red. Standard & Poor’s reported in February that 13 states are likely to have less than 75% of the cash needed for promised benefits.

In Crane’s corner are such financial heavyweights as investor Warren Buffett; John C. Bogle, founder of investment giant Vanguard Group Inc.; and William Bernstein, author of “The Four Pillars of Investing.”

The stakes are huge — especially for California, which has more than $350 billion in retirement funds covering teachers and other public employees. Falling short of the nearly 8% return that state money managers project for those funds could create deficits of tens of billions of dollars.

Taxpayers would have to ante up; retirees’ benefits are locked in by contract. Elected officials could be forced to raise taxes, cut services or borrow money. California’s teacher retirement fund already has a projected $20-billion shortfall.

“It is a very real problem,” Bogle said. “The financial consequences are staggering.”

A decade of returns at the rate Buffett has set for retirement plans at his companies — 6.4% — would leave California short more than $90 billion. That is more than the entire state budget for health and human services this year, and several times what the state is spending on its university system.

The Legislature has spurned such restrained forecasts.

Lawmakers in June rejected Crane’s appointment to the teacher retirement board by Schwarzenegger, after he had served almost a year. State Senate leader Don Perata (D-Oakland) said the job of trustees is “only to protect members’ benefits” — not to worry about the long-term effects of the benefits on the state budget.

Crane, who helped build a San Francisco investment firm that has arranged $250 billion in financings, said at his confirmation hearing: “Bless them if they can make it” to 8%. “I would assume a lower number. And I think there is a lot of evidence to back up my view.”

Bogle said he thinks California officials “are dreaming.”

Opponents of Crane, a Democrat, called him the operative of an administration eager to undermine the political power of public employee unions. Schwarzenegger, a Republican, campaigned last year to eliminate pensions for all new government workers and replace them with 401(k)-style accounts. The unions fought him, and he dropped the issue.

Many labor leaders and pension officials characterize as bogus the alerts being raised about the funds’ soundness.

“This is another way that folks who would like to see these benefits go away can undermine the plans,” said Pat Macht, spokeswoman for the California Public Employee Retirement System.

Macht notes that state pension investments have yielded returns averaging 9.2% over the last decade. That includes the 12 months that ended June 30, when profits on state investments exceeded 12%.

Stanford University professor William F. Sharpe, who won a Nobel Prize in economics, helped California develop its forecasts. And the state’s assumptions are in line with the predictions of economist Roger Ibbotson, whose predictions over the last 30 years have been uncannily accurate.

But author Bernstein, who is also a portfolio manager for wealthy individuals, is troubled that those who question the state’s numbers are brushed aside as partisans.

“This is not a right- or left-wing issue,” said Bernstein, a Democrat. “This is an issue of whether or not you can add.”

Bernstein notes that as the outlook for domestic stocks dims, California and other states are moving more of their money into risky places, such as high-tech start-ups, real estate and hedge funds. Returns on such investments are erratic, he said, and could easily fall short of standard stock market index funds over time.

Meanwhile, as corporate America has scaled back retirement benefits in recent years, California has headed in the opposite direction, enhancing benefits through legislation and contract negotiations with public employee unions. The result is the most generous public pensions of any state.

Under former Gov. Gray Davis, who received millions in campaign donations from unions, retirement packages for state workers were sweetened.

Davis signed legislation that based the pensions for many California workers on the highest annual income they earn while government employees; other states use an average of the top three years of earnings.

In addition, the age at which some employees could begin collecting was dropped to 50, and annual retirement payments were increased substantially.

When Schwarzenegger ousted Davis in the 2003 recall election, he made changing the pension system a centerpiece of his agenda, highlighting what he characterized as runaway costs.

Yet the 18 labor contracts negotiated by his administration have left in place most of the benefits the governor said the state can’t afford; the few concessions that union officials traded for pay increases did little to lower future retirement costs.

Long-serving state employees in California “can receive more annual income in retirement than when they worked,” according to a legislative report released last year.

The report said that when Social Security payments are factored in, “It takes just 20 to 30 years of work (that is, less than a full career) to have retirement income … equal to working pay.”

A typical 55-year-old government employee who earns $60,000 and has worked for the state for 20 years is entitled to $25,000 a year, plus Social Security and lifelong healthcare benefits. In most other large states, the pension for the same employee, if eligible at 55, would be less than $15,000 a year — thousands less in some states — plus health benefits.

Defenders say the state is well positioned to cover these costs.

“Reasonable people disagree about what the markets can do long-term,” said John Meier, a managing partner at Strategic Investment Solutions, a San Francisco firm that helps the state make projections.

Forecasts are made through a collaboration of actuaries, economists and investment experts from state government and private firms. They gauge the historical returns of various investment types, the outlook for growth in those places and the assumptions being used by other institutional investors.

“Our organization and a lot of other organizations believe that

Arizona and Virginia project an 8% return. Colorado and Pennsylvania anticipate 8.5%.

That’s all fine, said Zvi Bodie, a professor at Boston University School of Management, but there are no guarantees — and there’s the rub. Some experts are predicting a period of long-term market instability, he notes, and the state can’t afford to be off by a percentage point or two.

“Every study we have of stock market behavior says one thing we know for sure is: We don’t know for sure,” he said. “It is risky. There is no free lunch here.”

Bodie says the pressure for state number-crunchers to project strong earnings indefinitely is intense.

Optimistic projections free lawmakers from having to pull billions of dollars out of other state programs to increase the taxpayer contribution to the pension funds.

Meanwhile, officials at the California State Teachers Retirement System announced at a recent meeting that they are poised to raise investment in such risky areas as high-tech start-ups by roughly 67%.

“If they lose money, someone is going to have to bear that risk,” said Olivia S. Mitchell, executive director of the University of Pennsylvania Wharton School’s Pension Research Council. “Politicians today have promised benefits without explaining what will happen down the road if the system runs short.”

Times staff writer Dan Morain contributed to this report.

Link to full article: http://articles.latimes.com/2006/aug/14/local/me-pensions14